Set-Point Theory for Economics
Simply put, set-point theory postulates that after each recession a macroeconomy will permanently reset to a lower set-point and then again naturally rebound to normal growth rates.
There will be a permanent, irrecoverable economic setback below the pre-recession economy. The recovery will be driven by the private sector readjusting to the new reality.
This natural process will occur regardless of government action or economic policies.
GDP, corporate profits, employment numbers and other indicators are all up and the economy showed surprising, unexpected strength, during the Christmas season.
The U.S. economy is finally showing real signs of recovery after the housing bubble collapse, yet not bouncing back right away as quickly as in previous recessions.
Why this is so has been the subject of massive speculation.
Tim Duy Speaks
In an article titled “Still Caucious Heading into 2012” at the respected blog “Economist’s View“, new-age economist Tim Duy observed that Cardiff Garcia and others suggested that given the current slow recovery of the U.S. economy that:
the longer the cyclical downturn grinds on, the more likely it is that we will indeed see a new equilibrium path.
Duy disagrees this necessarily has to be the case, but acknowledges that current data suggests it could.
Looking beyond Duy…
Under set-point theory we are, in truth of fact, on the new “equilibrium path” already and that resetting to a new lower equilibrium path is a normal outcome of every recession.
The deeper the recession, the greater the set-point drop and the longer it takes an economy to resume normal economic growth.
That explains why this especially deep recession has taken so long to show signs of life again.
Despite $840 billion in government “stimulus” spending we’ve had a net loss of 8,000 total jobs in the last two years.
After four tortuous years, our long awaited return to normal growth is at hand. The set-point has finally been reached.
The Duy Dip
In his article Professor Duy published the graph on the left showing real GDP growth.
The green line shows the CBO‘s pre-recession projected lineal GDP growth path. The dark blue line with the giant southward curve – The Duy Dip – shows real GDP growth. The red extension is Duy’s best guess projected growth path that looks linear as well.
The graph at right shows a similar, but much smaller and much harder to see “Duy Dip” after the tech bubble collapse of 2001.
The Tale of Total Employment
Duy Dips show up much easier in total employment numbers than they do in real GDP data.
As clearly seen, both “Duy Dip”s above show a permanent loss of jobs, but when the recession ends then job growth returns to normal pre-recession growth rates.
Fewer jobs, fewer paychecks, lower real GDP. The direct link of total employment to real GDP is undeniable.
The linear job growth progression, particularly its slope, from 2003 to 2007 is a normal job growth pattern.
If the Bush tax cuts of 2001 and 2003 were responsible for the return of job growth then the slope of the job growth line should be steeper. It isn’t! Therefore, the Bush tax cuts did not end the recession and return us to prosperity.
Natural private sector economic forces took over after we reached the new set-point and normal growth resumed.
The Krugman Conjecture
In his New York Times column, “The Conscience of a Liberal”, Princeton economist Paul Krugman made a “back-of-the-envelope” analysis of current recovery optimism in an article titled, “The Soft Bigotry of Low Employment Expectations” on January 6th, 2012.
In it he suggests that a paltry 200,000 new jobs added in December is nothing to get excited about. According to Krugman, we are in much worse shape.
His main reasoning is this:
there are still about 6 million fewer jobs than there were at the end of 2007 — and that we would normally have expected to have added around 5 million jobs over a four-year period. So we are 11 million jobs down
Set-point theory hypothesizes that the 6 million jobs are permanently lost, never to return. What we are seeing now is job growth just returning back to its normal pre-recession linear pattern.
At best, The Fed and government policy can only tweak the economy. The private sector is the main driver of economic growth.
At this point, The Fed and government are pretty much tweaked out. We are seeing a natural return to pre-recession growth driven by the private sector.
The set-point theory postulates that we are just now returned to normal economic growth based on both real GDP and total employment numbers.
At this point the evidence is sparse, but compelling.
If true, then 2012 will have steady, stronger than expected economic growth if Europe doesn’t collapse.
Because of the depth of this recession and massive loss of jobs then the slope of linear growth in GDP and total employment will be steeper and surprise the experts. Krugman’s other 5 million who couldn’t find jobs will ultimately find work and some of the 6 million who permanently lost their jobs will find new ones within the new reality.
Government and The Fed, of course, will take full credit for a stronger economy. In truth, the private sector is doing all the heavy lifting.